The detection of earnings manipulation: The three-phase cutting plane algorithm using mathematical programming

Abstract

The primary goal of this study was to propose an algorithm using mathematical programming to detect earnings management practices. In order to evaluate the ability of this proposed algorithm, the traditional statistical models are used as a benchmark vis-à-vis their time series counterparts. As emerging techniques in the area of mathematical programming yield better results, application of suitable models is expected to result in highly performed forecasts. The motivation behind this paper is to develop an algorithm which will succeed in detecting companies that appeal to financial manipulation. The methodology is based on cutting plane formulation using mathematical programming. A sample of 126 Turkish manufacturing fi rms described over 10 fi nancial ratios and indexes are used for detecting factors associated with false fi nancial statements. The results indicate that the proposed three-phase cutting plane algorithm outperforms the traditional statistical techniques which are widely used for false fi nancial statement detections. Furthermore, the results indicate that the investigation of fi nancial information can be helpful towards the identifi cation of false fi nancial statements and highlight the importance of fi nancial ratios/ indexes such as Days' Sales in Receivables Index (DSRI), Gross Margin Index (GMI), Working Capital Accruals to Total Assets (TATA) and Days to Inventory Index (DINV). © 2009 John Wiley & Sons, Ltd.